How Your 401(k) May Be Hurting You
A popular prescription in the personal finance domain is to increase or maximize annual contributions to 401(k)s or similar retirement plans. However, one of the best financial decisions I’ve made over the past couple of years has been to move in the opposite direction -- to radically reduce my retirement account contributions.
For many years, the tax-deferred feature of traditional retirement accounts, plus the added sweetener of employer matches to contributed funds, found me seeking to "max out" voluntary retirement account contributions (this year the limit is north of $16,000 for 401(k)s).
A few years ago, I began assembling a quarterly personal balance sheet to obtain a better picture of my financial assets and liabilities. I noticed that the value of my retirement assets was relatively large compared to other asset categories. Meanwhile, the value of my current assets -- liquid financial assets such as cash that I could readily deploy in the present day -- were quite small and not growing.
On the liabilities side of my balance sheet, debt was growing. In addition to a mortgage (refinanced multiple times to pull out equity), I was lugging a home equity loan, a car loan, and a number of credit card balances.
Because the overall value of my assets was growing faster than my debt, it didn’t hit me right away that a potential problem was brewing. After all, the bottom line (literally) was that my net worth was increasing.
Veteran Minyans know that by early 2006, Minyanville content was peppered with concerns about potential for a severe economic and financial downturn, perhaps even a calamity. Central to most concerns was the amount of debt and leverage building in the system. Borrowed funds were increasingly being employed to support extravagant lifestyles as well as to speculate in financial assets. Should this debt and leverage rapidly unwind, severe deflationary forces could be unleashed.
Over the next year or so, Minyans learned that prudently managing risk ahead of such a scenario entailed reducing exposure to risky assets, increasing liquidity, and decreasing debt.
I began cutting my exposure to equities in my retirement accounts where most of my risky financial assets resided. Over the period of a year or so, pretty much everything went from blue chippers such as Johnson & Johnson (JNJ) to gold miners such as Newmont Mining (NEM).
However, I was having trouble getting more liquid and reducing debt. Sure, I was raising cash in my retirement accounts as I sold stock, but those funds weren't immediately available for present-day liquidity purposes without taking a significant penalty for early withdrawal. My paycheck wasn’t helping much, since funds that weren’t going toward monthly bills were being channeled to my 401(k).
It dawned on me that my personal financial strategy was out of balance. I was so focused on committing income to retirement accounts -- accounts that I wouldn't be able to access for many years (without significant penalty) -- that I was ignoring the need for building adequate resources to support living in the present.
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Early in my career, I put only enough into my 401(k) to get the employer match. The rest of my savings went into a taxable account. I felt like I didn't want to tie up funds in the retirement accounts if I didn't have to.
As the years went by, my salary increased and I started to get significant income from the taxable account. When I started to feel the pain of taxes on that investment income, I changed my strategy, deciding to max out my 401(k) contribution.
The result is that about 2/3 of my savings is in retirement accounts, 1/3 in taxable accounts.
Now, in my "semi-retired" years, the money in the taxable account gives me the flexibility to work part-time. I can access my savings when needed, without having to touch the retirement account money.
Then there is the "unknown" factor of our marginal tax rates in future vice present...maybe not so "unknown"!
At some point, I'd like to be 1/2 retirement, 1/2 taxable.
Hope things well w/ you.
Matt
Thx for the remarks.
Matt
Actually, if a prolonged low-return market environment takes hold, then most of the returns in your portfolio are likely to accrue through dividends and interest income. You are more likely to have better performance in a tax protected account assuming you have made suitable allocation in bonds and large cap value stocks.
A prolonged low-return market environment also argues for steady allocation of capital in the market through retirement account now to benefit from premium expansion later. This is better in retirement account so you are not necessarily hit with a tax bill when selling assets that you judge to have reached their near term potential. You no doubt experienced the good nature of tax sheltered accounts when you were reducing exposure to equities in your retirement accounts.
Of course you are still right in your central premise that you should only allocate into retirement account what you can and you don't need to mortgage the present to benefit the future.
If returns approach zero or negative (for risky assets) for a prolonged period, then there is little tax benefit to the retirement alternative. Plus there is uncertainty as to how retirement accounts will be taxed yrs from now.
As such, I like the risk/reward profile of taking control of these resources in the here and now.
Humbly,
Matt
My mortgage rate is 4 5/8%. Here's my thought process. I think there's a good chance that we're going to be in a low return world for a while. So if I pay down a mortgage at 4 5/8, the return on that project in terms of the interest expense saved is about 3% after tax. That's a lot better than the returns I can get if I put cash in a money mkt acct or the like right now.
Plus I'm heading toward being debt free.
Matt
Let us also consider the forced savings aspect. Most of us who are on this site are relatively good at saving and planning for the future, but is that the norm?? According to a survey, 51 percent of workers age 55 and up have saved less than $50,000 in retirement savings (not including the value of a primary residence). And 39 percent of workers in the same age group have saved less than $25,000 in retirement savings. Another survey estimates that one in five pre-retirees age 50 to 64 has less than $5,000 in retirement savings. In these cases, the issue is not picking the right vehicle for retirement, it's the actually disciplined SAVING that is required.
Should one lock all their income up in retirement savings they can't access until 59 1/2? Of course not. Life is all about the appropriate buckets. But in my opinion, for most individuals the 401(k) is the greatest thing they have at their disposal. For the undisciplined saver, the 59 1/2 restriction is a godsend!
Lastly, as far as living in a world of rising tax brackts, what about the ROTH 401(K)???? Let's try not to get too fancy in our personal financial plans. Sometimes plain vanilla is just fine.
Isn't this the whole idea of NPV (it's been a while since I've taken econ, just a SW dev now so please correct me if I'm wrong)? Today's $$$ are more expensive than tomorrow's, so you incur a cost to use today's $$$ to accelerate your debt payments. With such a small marginal difference (4.8->3%->now ~1%), even in today's market you can find some pretty safe investments that yield more than 1%.
Outside of the deflation scenario that was brought up earlier, what am I missing?
Shouldn't you only accelerate any payments to get rid of extra costs (such as PMI if you haven't reached 20% yet) and then level them off to the minimum and invest the difference?
Financially, I'm more balanced and flexible now. Perhaps I'm paying a 'premium' for this flexibility in terms of some foregone returns.
On the other hand, there were borrowing costs associated with my 'high retirement contribution' condition. Those costs are decreasing as I delever.
Am sure not for everybody, but personally I'm in better position to weather various scenarios now than I was before.
Humbly,
Matt
Right now there are a lotta folks putting on the dollar carry trade you describe. The risk is that either borrowing costs increase or investment returns decrease resulting in a negative carry. We saw big carry trade unwinds during the deflationary wave over the past 24 months or so.
I think there's still a good chance that significant deflationary pressures re-emerge. Thus I'd rather be out of debt and have strong cash balances.
Plus the freedom associated with being debt free is, to me, a worthy goal to achieve.
Respectfully,
Matt
You still contribute with after tax dollars, but you do have tax free growth.
And you can take out contributions without penalty at any time. (You're only taxed on the earnings within the IRA). It's a good retirement account that can double as an emergency fund.
We no longer own our own home, but your strategy is ours. *grin* We live debt free and are focused on cash savings, immediately accessible to us. There are a couple key points that you pick up in your work, that I think are worth repeating.
-401(k) is a government created structure, revocable or changeable at any time. There are many, many reasons to think a) taxes will be higher in the future and b)governments are not going to be able to resist raiding the cookie jar of retirement untaxed retirement funds. I don't think it's safe to assume that 401(k)s will be tax free 30 years from now.
-Outside of T-Bills or FDIC insured accounts, there are no absolutely "safe" investments. Even money markets can sustain losses of principal and return. On the other hand, it's absolutely guaranteed you will need a place to live. IMHO, one the safest "investments" you can make, once you are debt free, is to pay down the mortgage.
And more generally, bankers are in business to make money. Mortgages were consistently profitable until they decided to "innovate" in the last decade with loans people couldn't pay back. Generally speaking, I try to be on the same side of the trade as people who make money. Bankers issue mortgages, they don't have them. ;)
Here seems to be an article and discussion about what you were asking.
http://www.morningstar.com/cover/videocenter.aspx?id=317226
Cheers.
